Babson Capital White Paper

August 2010

Middle-Market Mezzanine Debt

ABSTRACT
In the current environment of constrained bank lending resulting from the recent financial crisis, there is increasing demand particularly in the middle market for mezzanine debt. Mezzanine debt is the portion of a corporations capital structure positioned below senior debt, but above equity. It is considered by some investors as a fixed income asset that has higher yields than corporate bonds and by others as an alternative investment with lower volatility than private equity. By its nature, mezzanine debt can provide returns that are not highly correlated with other asset classes. Middle-market mezzanine transactions are small in size ($8 million to $75 million), privately structured, and closely held. Though there are risks inherent in any private and illiquid market, historical returns have been high, with the top-quartile middle-market mezzanine funds ranging from 12-18% over the past 20 years. The unique characteristics of middle-market mezzanine has made the asset class an attractive addition to diversified portfolios.

Middle-Market Mezzanine Debt

A VALUED FINANCING TOOL FOR COMPANIES AND VALUABLE DIVERSIFIER FOR INVESTORS

Middle-market mezzanine debt is a privately structured security that can come in many different forms, including second-lien debt, subordinated debt with or without warrants, convertible debt or preferred equity. The middle-market can be defined in a variety of ways, but is generally associated with companies (or issuers) with total enterprise value between $50 million and $300 million and a mezzanine need of $8 million to $75 million. In developed economies, mezzanine debt is most often used by private-equity firms in conjunction with leveraged buyouts, filling the gap within the companys capital structure between the private-equity investment and more senior loans and/or bonds. It is usually structured with a high yielding cash-interest component and it can come with an equity kicker a contingent common-equity interest.
FIGURE 1: MEzzANINE DEBT AND A TyPICAL CAPITAL STRUCTURE
% 100 80 60 40 20 0 Equity Mezzanine Senior Debt

Source: Babson Capital

Mezzanine debt can be attractive for middle-market companies because it is more flexible than senior debt and less expensive and less dilutive than common equity (see Table 1). Though senior debt is structured with the lowest contractual return attributes, it has the benefit of repayment priority over mezzanine debt and equity. Senior debt also has the most conservative structural attributes for lower risk. Equity capital, on the other hand, as the most junior layer in the capital structure, has the highest return expectations and the greatest control rights over the strategic actions of management. Mezzanine financing is a hybrid of senior debt and equity; it is more expensive than senior debt but is a less expensive form of capital than equity. Its
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TABLE 1: DIFFERENT CAPITAL SOURCES USED By A MIDDLE-MARkET COMPANy

SENIOR BANk LOANS Security Ranking Covenants Term Coupon Rate Equity kicker Prepayment penalties Capital providers Recovery Source: Babson Capital Secured Highest Tight Short term/Demand Floating LIBOR plus spread None Yes Banks High MEzzANINE Subordinated Middle Flexible Long term/Patient Fixed Risk adjusted Warrants Yes Private capital Low/medium EqUITy None Lowest None Patient Dividend Market adjusted Shares No Private capital Low

returns are generated through negotiated combinations of contractual interest payments and equity-related capital appreciation. It is also beneficial to the borrower because it does not require management control, has a longer term predefined exit arrangement, and is less dilutive to current equity investors. The more equity capital required in a transaction, the lower the return expectations for the equity holders investors at the riskiest layer of the capital structure. Mezzanine debt allows a company to reduce its cost of capital and boost both its return on equity and its absolute profits. Table 2 illustrates how the inclusion of mezzanine debt in a capital structure can lower the overall cost of capital. The amount of senior and mezzanine debt available to support a leveraged buyout determines the extent to which equity capital is required to complete the transaction. In general, senior debt providers do not have a participation in the equity value of their borrowers. Therefore, the goal of senior lenders is to be repaid the loan and to minimize the risk of loss. To ensure repayment of the loan, senior lenders will limit their exposure to conservative estimates of the borrowers collateral or free cash flow. Mezzanine investors, also known as mezzanine lenders, are paid a higher yield and, in many cases, have a small participation in the growth of the borrowers equity value. Therefore, mezzanine investors are willing to assume more risk than senior debt providers but within the context of their enhanced return expectations.
TABLE 2: LOWERING ThE COST OF CAPITAL WITh MEzzANINE DEBT*
COST OF CAPITAL (%) Senior debt Mezzanine debt Equity 7 15 25 CAPITAL STRUCTURE INCLUDING MEzzANINE DEBT (%) 45 15 40 15.4% CAPITAL STRUCTURE CAPITAL STRUCTURE WIThOUT MEzzANINE WIThOUT DEBT DEBT (%) (%) 45 0 55 16.9% 0 0 100 25.0%

Weighted average cost of capital * Illustration Source: Babson Capital

Babson Capital White Paper August 2010

PRIVATELy NEGOTIATED, hIGhLy CUSTOMIzED

Insurance companies and other institutional investors have historically been the main providers of middle-market mezzanine debt. Over the last decade, however, mezzanine funds have been formed to take advantage of the attractive returns that are potentially available. Middle-market mezzanine debt instruments are privately negotiated with highly customized terms. Similar to other credit-based lending structures, mezzanine investors predicate their decision to make a particular investment on a companys expected future cash flow. To protect against the potential of inadequate cash flows, the mezzanine debt will be structured to contain financial and other protective covenants that require the issuer to maintain specific minimum performance and operational standards. The covenants will almost always provide the borrower with more flexibility than the senior debt covenants. As a secondary source of repayment, the mezzanine lender may, occasionally, require a subordinate claim on corporate assets, second to both the senior and junior secured lenders, but U.S. mezzanine lenders generally provide unsecured debt. Mezzanine debt typically matures between six and eight years after closing, a period during which interest must be paid as scheduled to avoid default. Most mezzanine transactions are structured with no amortization requirements, and repayment of the full principal amount is due at maturity. If the principal is not paid at maturity, it is also considered to be a payment default. It is unusual for mezzanine debt to remain outstanding to maturity. Often, the borrower will seek to retire or replace the mezzanine debt with less expensive capital as soon as practical. Thus, mezzanine debt tends to remain outstanding for approximately three to five years from the initial funding. In many cases, prepayments occur due to the sale of the borrower by the owner, a private-equity sponsor. If the sponsor has yet to sell the company before the maturity date, it is normally for one of two reasons: the deal has not been successful and has been restructured and/or recapitalized, or further acquisitions have been made and integration with the original company is needed. In the latter case, if a new senior debt obligation is structured, the holders of the mezzanine debt will be brought into the discussion and extension, replacement or rollover of the mezzanine debt will be negotiated.
COUPONS DRIVE RETURNS, BUT WARRANTS OFFER EqUITy UPSIDE

In a typical mezzanine-debt investment, return is principally driven by the cash coupon. The cash coupon is paid on a quarterly or semi-annual basis and has historically been set at 12-13% per annum. Cash coupons may be supplemented with capitalized interest (also known as payment-in-kind or PIK ), which can range from 0-4%. At the closing of a mezzanine investment, the mezzanine debt is typically funded at par less an upfront fee, which can range from 1.0-2.5%; in other words, the upfront fee goes to the lender as a discount to the par value of the debt. Finally, returns on mezzanine debt can be supplemented with warrants. Warrants give investors the right to buy a specific number of common shares in a company at a set exercise price per share. The exercise price is usually set at a nominal cost per share. The potential for future equity participation gives investors the ability to share in the capital gains of the company. Warrants can account for 0-8% of additional yield on the mezzanine investment depending on the performance of the borrower.

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FIGURE 2: AVERAGE COUPON OF MEzzANINE DEALS FINANCED By BABSON CAPITAL ThROUGh ThE yEARS
% 14 Post Asian Financial Crisis Post 2007 Crisis 13 Post S&L Crisis 12 Average = 12.2% Post 9/11 Crisis

11

10

1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010

Source: Babson Capital as of July 11, 2010. Past performance is no guarantee of future results

Coupons paid on mezzanine debt, like other credit investments, tend to peak during periods of financial market stress, as credit becomes constrained and concerns over default risk heighten. As can be seen in Figure 2, the average coupon of mezzanine deals spiked after each financial crisis during the past two decades. In the event of prepayment of the mezzanine debt by the company, there are prepayment penalties to partially offset the loss of the cash-coupon payments. The market standard is to set prepayment penalties on a declining scale starting at up to 4% of par in year one and generally ending after year three. Call protection can thus serve as a secondary benefit to the investor. To meet the investors targeted overall returns for their capital invested, mezzanine debt is structured with various combinations of each of the four components of return: cash interest, PIK interest, closing fees and an equity participation right. The presence of PIK interest or warrants in a mezzanine structure is not constant and the absolute level of each will vary depending on the risk profile of the company, competitive factors, macroeconomic dynamics and a given investors investment philosophy. Assuming a four-year holding period, the coupon and fee components on average account for roughly 75% of the all-in return for mezzanine investments structured with warrants. The remaining 25% of the total return will be generated by the warrants. The investor benefits from capital gains on the sale of the common stock obtained through exercise of its warrants.
FIGURE 3: AVERAGE RETURNS OF MEzzANINE FUNDS USING ANNUAL IRRS %
40 35 30 25 20 15 10 5 0 -5 -10 1988 1991 1994 1997 2000 2003 2006 2009

Source: ThomsonOne as of December 31, 2009

Babson Capital White Paper August 2010

FOR RETURNS, MANAGERS MATTER

Given the private nature of the mezzanine-debt market, there are no benchmarks available for historical performance comparisons. However, mezzanine fund returns can be used to illustrate historical market returns (see Figure 3). Strong performance and lower return volatility over the past decade have increased the popularity of middlemarket mezzanine debt. Between 2000 and 2009, the mezzanine asset class showed stronger average returns and less volatility of performance versus private and public equity (see Figure 4).
FIGURE 4: MEzzANINE VS. OThER ASSET CLASSES RANgE OF ROLLINg ONE-YEAR RETuRNS 2000-2009
% 40 30 20 10 0 -10 -20 -30 -40 -37.0 S&P 500 -27.6 1.2% -2.4 -14.2 11.6 6.4% 7.1% 8.5% -1.7% 10.7%

Indicates average return 2000-2009

28.7 29.1 32.3

38.1 31.7

-31.0 Buyout

-34.4 Venture Mezzanine

BC Agg

All PE

Public Markets

Private Markets

Source: Preqin as of June 2009

Still, selecting the right fund manager matters, as the return distribution between the best and worst funds can be wide (see Figure 5). Funds in the 100th percentile returned 280% (cash-on-cash returns) in 1993 and 230% in 1999; the worst performing funds almost lost all their capital in 1997, 2001 and 2006.
FIGURE 5: CUMULATIVE PERFORMANCE By PERCENTILE
% 280 230 180 130 80 30 -20 -70 -120
19 90 19 91 19 92 19 93 19 94 19 95 19 96 19 97 19 98 19 99 20 00 20 01 20 02 20 03 20 04 20 05 20 06 20 07 20 08 20 09

100th percentile

75th percentile

50th percentile

25th percentile

0th percentile

Source: ThomsonOne as of December 31,2009

It is common for mezzanine fund managers to show their returns against the upper quartile to illustrate their ranking within the mezzanine industry. Returns for the upper quartile of funds have ranged from 12-18% over the past two decades (see Figure
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6). Median returns ranged between 7-13% over the same time period. Top quartile investment performance is usually attributed to a well defined investment strategy, an experienced credit-focused investment team and an established origination function.
FIGURE 6:
% 18.0 16.0 14.0 12.0 10.0 8.0 6.0 4.0 2.0 0.0

CUMULATIVE PERFORMANCE By qUARTILE

90

91

92

93

94

95

96

97

98

99

00

01

02

03

04

05

06

07

08

19

19

19

19

19

19

19

19

19

19

20

20

20

20

20

20

20

20

20

Upper

Median

Lower

Source: ThomsonOne as of December 31,2009

RISkS INVOLVED IN INVESTING IN MIDDLE-MARkET MEzzANINE

Investing in middle-market mezzanine debt involves risks that range from the more general risks of fixed income investments to those specific to the characteristics of mezzanine debt. As with other debt instruments, there is a risk of issuer default but this risk is compounded by the fact companies borrowing mezzanine debt are more apt to have a leveraged balance sheet. Additionally, the middle-market focus means that the companies will generally be smaller, more concentrated in their business activities, have fewer capital-raising alternatives and limited management depth. The debt of most middle-market companies is not rated by rating agencies. However, these borrowers are widely considered to be below investment grade. In the event of default, recoveries can be low because mezzanine debt claims are subordinate to senior debt. Lack of liquidity is also another risk factor associated with middle-market mezzanine debt. It is all of these risks that provide opportunities for experienced and stable investors with an in-depth understanding of both quantitative as well as qualitative risk attributes, and an ability to react to operational and financial issues during the long life of a middle-market mezzanine investment, to generate strong absolute returns.
A GLOBAL COMPARISON

While the middle-market mezzanine debt market may be more developed in the U.S., this form of financing is also used in many developed markets around the globe, such as Europe and Australia. Like the U.S., middle-market mezzanine debt in Europe and Australia is a source of capital to sponsor-backed leveraged buyouts of private companies. Deals in all three regions may also have equity kickers in the form of warrants. However, a key difference is that U.S. mezzanine loans tend to be junior unsecured debt, whereas Australian and European mezzanine loans are junior secured and share the same collateral as senior debt providers, which can have positive implications on the recovery rates in the event of default. The following table details similarities and differences across all three debt markets.
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TABLE 3: GLOBAL MIDDLE-MARkET MEzzANINE FEATURES

ChARACTERISTIC Capital Structure U.S. MEzzANINE LOANS Junior unsecured Contractually subordinated AUSTRALIAN MEzzANINE LOANS Junior Secured Benefits from the same collateral as senior banks but on a second ranking and subordinated basis Both fixed and floating with PIK component 1600 - 1900 bps (all-in) EUROPEAN MEzzANINE LOANS Junior Secured Benefits from same collateral as senior banks but on a second ranking and subordinated basis Floating with PIK component Senior Mezzanine: Euribor + 1300 - 1400 bps Junior Mezzanine: Euribor + 1600 - 1700 bps Both warranted and warrant less deals in the market 7 - 10 years Non-call protection typical 100 million to 500 million

Fixed / Floating Pricing

Primarily fixed with PIK component 1600 - 1800 bps return (middle market) 1100 - 1500 bps return (large cap)

Equity kicker

Both warranted and warrantless deals in the market 6 - 8 years Declining premium Some non-call protection Middle market transactions rarely exceed uS$50 million Large cap market uS$50 million to uS$200 million Financial sponsor-backed LBOs of private companies or growth financing for capital investments or acquisitions by unsponsored private companies

Both warranted and warrantless deals in the market 5 - 7 years (avg 5.5-6 years) Non-call protection typical Au$5 million to Au$150 million

Term Prepayment Penalties Typical Deal Size

Public / Private

Financial sponsor-backed LBOs of private companies, public to private, or divestitures by private or public companies Second ranking security with financial and non-financial covenants based on senior terms

Financial sponsor-backed LBOs of private companies

Security Package / Same covenants as banks, Covenants but slightly looser, maintenance-based

Similar covenant package to senior loans with maintenance financial covenants Second or third ranking

Source: Babson Capital, Babson Capital Europe, Babson Capital Australia

SUMMARy

Middle-market mezzanine debt stands out as a special asset class within the spectrum of fixed income and alternative investments. Junior to traditional senior-secured loans yet senior to equity, it helps provide capital to growing middle-market companies globally. From the borrowers standpoint, mezzanine debt provides a flexible and patient form of financing and allows the company to reduce its total cost of capital and boost both its return on equity and profits. Each mezzanine deal is privately negotiated. As such, the lender is able to customize the terms of each deal to the needs of the investor and the borrower. Returns to the investor are driven by the coupon (both cash payments and PIK), up-front fees, and additional yield that may be provided by warrants and/or equity co-investments. Opportunities in mezzanine debt are not restricted to the U.S., as established mezzanine markets also exist in Europe and Australia. With historical returns ranging from the mid-to-high teens, middle-market mezzanine debt can be considered a higher yielding fixed income asset (compared with public high yield bonds) or as an alternative asset with lower risk than private equity. Either way, mezzanine debt stands as a worthwhile addition to a diversified portfolio.
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DISCLOSURE Past performance is no guarantee of future results. This document contains the current opinions of the Portfolio Manager but not necessarily those of Babson Capital Management LLC. Such opinions are subject to change without notice. Nothing in this document is intended to be taken by any person as investment advice, or a recommendation to buy, hold or sell any security or other investment, or an offer to sell or a solicitation of offers to purchase any security or other investment, nor does it purport to be a complete description of the terms of or the risks or potential conflicts of interest inherent in any actual or proposed investment or other transaction. Prior to entering into any investment, prospective investors should determine, in consultation with their own legal, tax, regulatory, accounting and/or financial advisors, the economic risks and merits, as well as the legal, tax, regulatory and accounting characteristics and consequences, and the overall suitability, of the transaction from the investors own standpoints, and decide whether they are able to bear such consequences and assume such risks. Although the information presented in this document has been obtained from sources that Babson Capital believes to be reliable, Babson Capital cannot and does not make any representation as to its accuracy, validity, timeliness or completeness for any purpose, nor does Babson Capital undertake to update any of the information presented herein. Past performance of markets and instruments is no guarantee of future results, and investments may lose money. Babson Capital and our affiliates, officers, directors and employees may from time to time hold longor short positions in and buy or sell securities or financial instruments discussed in or affected by the statistics discussed in the document. Opinions expressed are our current opinions as of the date appearing at the top of this document. Australia: The information contained in this presentation, is being provided by Babson Capital Management LLC (Babson Capital), a foreign company registered in Australia (ARBN 132 880 007), and by its officers and employees in good faith in relation to the facts known to it at the time of preparation. It is being provided for informational purposes only, and is not meant to provide opinions, advice or recommendations. Babson Capital is exempt from the requirement to hold an Australian financial services license under the Corporations Act of Australia in respect of the financial services. Babson Capital is regulated by the U.S. Securities and Exchange Commission under U.S. laws which differ from Australian laws. Babson Capital has prepared this document without consideration of the investment objectives, financial situation or particular needs of any individual investor, and you should not rely on the opinions, advice, recommendations and other information contained in this document alone. This document contains general financial markets information only.
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